ET in the classroom: What is Islamic finance?

Islamic finance refers to a financial system that is consistent with the principles of Sharia, the sacred law of Islam. It is different from regular banking in that it prohibits earning of interest (or riba) through the business of lending. It also prohibits direct or indirect association with businesses involving alcohol, pork products, firearms and tobacco. It also does not allow speculation, betting and gambling.

How does it work?

Islamic finance takes the form of Islamic banking and Islamic insurance, also known as Takaful.

Islamic banking is done in five ways:

1. Mudarabah, a profit-sharing agreement

2. Wadiah, a safe keeping arrangement

3. Musharakah, or a joint venture for a specific business

4. Murabahah, cost plus arrangement where goods are sold with a pre-determined margin of profit

5. Ijirah, a leasing arrangement

Takaful is a form of mutual insurance based on partnership and collective sharing of risk by a group of individuals.

How has Islamic banking progressed in recent years?

Islamic banking is most prevalent in Malaysia. It is spreading rapidly in West Asia, where the population is predominantly Muslim. New global financial centres such as Singapore, Hong Kong, Geneva, Zurich and London have made changes in regulations to accommodate the Islamic finance industry, which is nearly a trillon dollar in size now.

Indian regulations do not allow Islamic banking but the government is considering allowing it.

What restricts the growth of Islamic finance?

Most banks conducting Islamic operations have a panel of Muslim scholars called Sharia committee or Sharia board, which determines whether a product or practice complies with Islamic provisions. Also, the accounting is done differently for which there is an official standard-setting body known as the accounting and auditing organization for Islamic financial institutions. The strict code makes Islamic banking a very niche product.